Tag Archives | bankruptcy

Z Score Model

See Also:
Financial Distress Costs
Insolvency
Bankruptcy Code
What is Inflation?
Recession Definition

Altman Z Score Model Definition

The Altman Z Score model, defined as a financial model to predict the likelihood of bankruptcy in a company, was created by Edward I. Altman. Altman was a professor at the Leonard N. Stern School of Business of New York University. His aim at predicting bankruptcy began around the time of the great depression, in response to a sharp rise in the incidence of default.

Altman Z Score Model Explanation

To Dr. Altman, z score explained an important issue of the time. For this, he used a weighting system combined with a set of four or five financial ratios to predict a company’s probability of failure. Altman created three different Z Score Models that each serve unique purposes. The original Z Score Model was developed in 1968. It was made from the basis of statistical data from public manufacturing companies and eliminated all companies with assets less than $1 million. However, this original model was not intended for small, non-manufacturing, or private companies. Later, Dr. Altman developed two additional models to the original Z Score Model. In 1983, the Model “A” Z-Score was developed for use with private manufacturing companies. Model “B” was developed for non-public traded general firms and included the service sector. Different models have different variables, weighting and overall predictability scoring systems.


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Altman Z Score Purpose

The purpose of the Z Score Model is to measure a company’s financial health and to predict the probability that a company will collapse within 2 years. It is proven to be very accurate to forecast bankruptcy in a wide variety of contexts and markets. Studies show that the model has 72% – 80% reliability of predicting bankruptcy. However, the Z-Score does not apply to every situation. It can only be used for forecasting if a company being analyzed can be compared to the database.

Altman Z Score Analysis

In general analysis, the lower the Z-Score, the higher risk of bankruptcy a company has, and vice visa. Different models have different overall predictability scoring. Probabilities of bankruptcy in the above ranges are 95% for one year and 70% within two years.

1. Original Z-Score for public manufacturing companies:

Z-Score        Forecast
Above 3.0        Bankruptcy is not likely
1.8 to 3.0       Bankruptcy can not be predicted-Gray area
Below 1.8        Bankruptcy is likely

2. Model A Z-Score for private manufacturing companies:

Z-Score         Forecast
Above 2.9         Bankruptcy is not likely
1.23 to 2.9       Bankruptcy can not be predicted-Gray area
Below 1.23        Bankruptcy is likely

3. Model B Z-Score for private general companies:

Z-Score         Forecast
Above 2.60Bankruptcy is not likely
1.10 to 2.60Bankruptcy can not be predicted-Gray area
Below 1.10Bankruptcy is likely

Altman Z Score Formula

1. Original Z-Score formula for public manufacturing companies:

Original Z-Score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5

2. Model A Z-Score for private manufacturing companies: this model substitutes the book values of equity for the Market value in X4 compared to original model.

Model A Z-Score = 0.717X1 + 0.847X2 + 3.107X3 +0.420X4 +0.998X5

3. Model B Z-Score for private general companies: this model analyzed the characteristics and accuracy of a model without X5 – sales/total assets.

Model B Z-Score = 6.56X1 + 3.26X2 +6.72X3 +1.05X4

X1 = working capital/total Assets. It measures the net liquid asset of a company relative to the total assets.

X2 = retained earnings/total Assets. It measures the financial leverage level of a company.

X3 = earnings before interests and taxes/total Assets. It measures productivity of a company’s total assets.

X4 = market value of equity/book value of total liabilities. It measures what portion of a company’s assets can decline in value before the liabilities exceed the assets.

X5 = sales/total Assets. It measures revenue generating ability of a company’s assets.

Altman Z Score Calculation

If:
Working Capital = $5,000,000
Retained Earnings = $1,000,000
Operating Income = $10,000,000
Market Value of Equity = $2,000,000
Book Value of Total Liabilities = $500,000
Sales = $15,000,000
Total Assets = $3,000,000

Working Capital / Total Assets = $5,000,000 / $3,000,000 = 1.67
Retained Earnings / Total Assets = $1,000,000 / $3,000,000 = .33
Operating Income / Total Assets = $10,000,000 / $3,000,000 = 3.33
Market Value of Equity / Book Value of Total Liabilities = $2,000,000 / $500,000 = 4
Sales / Total Assets = $15,000,000 / $3,000,000 = 5

Model A Z-Score = 0.717X1 + 0.847X2 + 3.107X3 +0.420X4 +0.998X5 = .717(1.67) + .847(.33) + 3.107(3.33) + .420(4) + .998(5) = 18.49321

Altman Z Score Example

For example, Benny is the CFO of a company which manufactures custom car parts. The company, which started as a local car shop, has evolved into a regional product provider. Benny has been part of the team since he gained his CPA license and has helped the company manage the success it acquired.

With the recent credit market situation, Benny wants to make sure his company will be able to meet the financial obligations it has committed to. Benny decides to calculate for the Altman Z Score; manufacturing has been hit hard enough that he feels he has to. With this decision, he begins assembling company financial reports to find the factors of the Altman Z Score equation as they relate to his company.

Benny performs this calculation:

If:
Working Capital = $5,000,000
Retained Earnings = $1,000,000
Operating Income = $10,000,000
Market Value of Equity = $2,000,000
Book Value of Total Liabilities = $500,000
Sales = $15,000,000
Total Assets = $3,000,000

Working Capital / Total Assets = $5,000,000 / $3,000,000 = 1.67
Retained Earnings / Total Assets = $1,000,000 / $3,000,000 = .33
Operating Income / Total Assets = $10,000,000 / $3,000,000 = 3.33
Market Value of Equity / Book Value of Total Liabilities = $2,000,000 / $500,000 = 4
Sales / Total Assets = $15,000,000 / $3,000,000 = 5

Model A Z-Score = 0.717X1 + 0.847X2 + 3.107X3 +0.420X4 +0.998X5 = .717(1.67) + .847(.33) + 3.107(3.33) + .420(4) + .998(5) = 18.49321

Altman Z Score Example Conclusion

Benny’s employer has a z score well over 2.9, making bankruptcy very unlikely. This is just as Benny expected. Still, he is happy to do the work. He knows that if he continues to pay attention to the finances of the company he can control them. In this way Benny knows he can direct the finances of the company, turning inefficiency into profit.

Next, Benny does research and finds the Altman Z Score for private companies in his industry. He can use this information to compare his company to common best practices. If he is below the standard, he can find how others have solved the problem. If he is above the standard, he can expand projects which differentiate his company from the average firm.

Benny presents his work in true fashion of Altman; Z-Score tables are made, manufacturing competitive analysis is done, and the project is completed to excellent standards. The effort finally pays off when Benny is offered a bonus of stock options. He feels even closer to the company he has developed his abilities in.

z score model

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Reorganization Definition

See Also:
Debtor in Possession
Financial Distress Costs
Insolvency

Reorganization Definition

Reorganization is when a bankrupt company restructures its debt obligations without going out of business. During reorganization, the debtor retains ownership of its assets and continues business operations. The debtor then renegotiates the terms of its debt obligations to creditors. If a company is having financial trouble and is at risk of defaulting on loan payments, that company may want to consider reorganization to consolidate debts and adjust loan agreements to make payments more manageable.

Reorganization vs Liquidation

Reorganization vs liquidation are two types of bankruptcy processes. In a reorganization, the debtor retains ownership of its assets and continues business operations while renegotiating debt repayments with creditors.

In a liquidation, the creditors seize control of the debtors assets and sell them to pay off the debt. Furthermore, the debtor goes out of business and ceases normal operations. After liquidation, the entity technically no longer exists.

Chapter 11 Reorganization

Chapter 11 bankruptcy is a type of bankruptcy proceeding outlined in the Bankruptcy Code. It is also a reorganization procedure.

When a financially distressed entity files for chapter 11 bankruptcy, the entity continues to operate while it restructures its debt obligations. The entity is given a limited amount of time in which to restructure the debts. During this time the entity is protected from creditors.

Reorganization bankruptcies are usually more complex than liquidation bankruptcies. Companies usually file for Chapter 11 bankruptcy.

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Reorganization Definition, Reorganization vs Liquidation

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Reorganization Definition, Reorganization vs Liquidation

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Other People’s Money

Other People’s Money (OPM)

In finance, other people’s money, or OPM, is a slang term that refers to financial leverage. Other people’s money refers to borrowed capital that is used to increase the potential returns as well as the risks of an investment. OPM can be used by individuals or by corporations.

Using other people’s money is considered a double-edged sword – it cuts both ways. If an investment that is levered with other people’s money turns out to be profitable, then the profits are magnified by the effects of the leverage. However, if the levered investment goes sour, then the investor that utilized other people’s money can incur steeper losses.

Capital structure refers to a company’s mix of debt and equity financing. Many factors must be considered when determining the optimal mix of debt and equity financing. Increasing leverage, or the use of other people’s money, up to a certain degree can benefit a company by increasing its tax shield. On the other hand, more leverage can increase the risk of default and the incurrence of bankruptcy or financial distress costs.

Other People’s Money Example

Here is an example that demonstrates the risk-return trade-off of using financial leverage, or other people’s money. Let’s say an investor has $100 and plans to invest it in a security that either gains 20% or losses 20% over the course of the year.

If the investment gains 20%, then the investor ends the year with $120, or a profit of $20. However, if the investment losses 20%, then the investor ends the year with $80, or a loss of $20. In either case, the gains and losses represent a reasonable amount in comparison to the original invested capital.

Now, let’s examine the same investment, but with the investor using other people’s money as financial leverage. Let’s say the investor borrows $400 and, along with his original $100, invests a total of $500 in the same investment. The investment will end the year either up 20% or down 20%.

If the investment gains 20%, then the investor ends the year with $600, or a profit of $100. This represents a 100% increase in the original invested capital. On the other hand, if the investment losses 20%, then the investor ends the year with $400, or a loss of $100. This represents a loss of 100% of the original invested capital.

As you can see, the use of other people’s money, or financial leverage, dramatically increased both the upside gains and the downside losses of the investment.

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Other People's Money
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Other People's Money

See Also:
Angel Investor
Venture Capital
Line of Credit (Bank Line)
What are the 7 Cs of banking
Working Capital

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Adjusted Present Value (APV) Method of Valuation

See Also:
Valuation Methods
Net Present Value Method
Internal Rate of Return Method
NPV vs IRR
Capitalization

Adjusted Present Value (APV) Method of Valuation Definition

Adjusted Present Value (APV) Method of Valuation is the net present value of a project if financed solely by equity (present value of un-leveraged cash flows) plus the present value of all the benefits of financing. Use this method for a highly leveraged project.

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Adjusted Present Value Method Calculation

1. Calculate the value of un-leveraged project by discounting the expected free cash flow to the firm at the un-leveraged cost of equity.

2. Then, calculate the expected tax benefit from a given level of debt by discounting the expected tax saving at the cost of debt to reflect the riskiness of this cash flow.

3. Finally, evaluate the effect of a given level of debt on the default risk of a company and expected bankruptcy costs.

Thus, the APV calculation is as follows:

Value of the operating assets = Un-levered firm value + PV of tax benefits – Expected Bankruptcy Costs

Adjusted present value = value of the operating assets + value of cash and marketable securities.

Adjusted Present Value Application

APV method is very similar to traditional discounted cash flow (DCF) model. However, instead of weighted average cost of capital(WACC), cash flows would be discounted at the cost of assets, and tax shields at the cost of debt. Technically, an APV valuation model combined impact of both growth and the tax shield of debt on the cost of capital, the cost of equity, and systematic risk. Thus it is a more flexible way of approaching valuation than other method. However, APV method has some flaws. Company value will be overstated when adding the tax benefits to un-levered company value to get the levered company value, especially for some companies with high debt ratios.

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Adjusted Present Value (APV) Method of Valuation

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Adjusted Present Value (APV) Method of Valuation

 

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Insolvency Definition

See Also:
Chapter 11 Bankruptcy
Chapter 7 Bankruptcy
Bankruptcy Costs
Bankruptcy Information
Fixed Charge Coverage Ratio Analysis

Insolvency Definition

Insolvency is the inability to pay debts when they are due. It also occurs when a company’s liabilities exceed the value of its assets, if you cannot readily cover these the assets into cash to repay debts. Apply this to either individuals or organizations.

Insolvency Leads to Bankruptcy

Insolvency often leads to bankruptcy. However, you can avoid bankruptcy if the debtor can restructure or renegotiate delinquent debt payment. Out-of-court renegotiation of delinquent debt is called a workout.

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insolvency

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insolvency

 

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Financial Distress Costs

See Also:
Financial Accounting Standards Board
Financial Instruments
Hedging Risk
Financial Ratios
Finance Beta Definition

Financial Distress Costs

In finance, consider a company to be in financial distress when it is having difficulty making payments to creditors. Financial distress may lead to bankruptcy. The more debt a company uses to finance its operations the more it is at risk of experiencing financial distress. There are several costs associated with financial distress, including bankruptcy costs, distressed asset sales, a higher cost of capital, indirect costs, and conflicts of interest.

Bankruptcy Costs

The more debt a company takes on, the more it risks being unable to meet its financial obligations to creditors. A highly leveraged firm is more vulnerable to a decrease in profitability. Therefore, a highly levered firm has a higher risk of bankruptcy.

Bankruptcy costs vary for different types of firms, but they typically include legal fees and, losses incurred from selling assets at distressed fire-sale prices, and the departure of valuable human capital. The way to measure bankruptcy cost is to multiply the probability of bankruptcy by the expected cost of bankruptcy. A company should consider the expected cost of bankruptcy when deciding how much debt to take on.

Indirect Costs of Financial Distress

There are also several indirect costs associated with financial distress. When a company is experiencing financial distress, conservative managers may cut down on research and development, marketing research, and other investments to spare cash. The firm may also incur opportunity costs if trepid managers pass on risky corporate projects.

Also, financial distress can affect a firm’s reputation. A company in financial distress may lose customers, be forced to pay a higher cost of capital, receive less favorable trade credit terms from suppliers, and be vulnerable to tactics from aggressive industry competitors.

Financial Distress and Conflicts of Interest

Financial distress can incur costs associated with the conflicting self-interests of creditors, managers, and owners.

When a company in financial distress is confronted with a risky investment opportunity, creditors would prefer the company not engage in the risky investment – they would rather the company preserve its assets so they will be able to collect what’s owed to them in the event of default or bankruptcy.

Investors, or owners, on the other hand, would prefer the company to go forward with the risky investment. If the company foregoes the investment, owners don’t benefit. If the company does go for the risky investment, owners have at least some upside gain potential.

While managers may be either conservative in the face of a risky opportunity in order to try to preserve their jobs, or they may be more inclined to take the risk if they side with the shareholders or see the opportunity as a chance to increase personal gain.

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financial distress costs

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financial distress costs

Source:

Higgins, Robert C. “Analysis for Financial Management,” McGraw-Hill Irwin, New York, 2007.

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Debtor in Possession

Debtor in Possession

A debtor in possession, or DIP, is a company undergoing a Chapter 11 bankruptcy reorganization. In Chapter 11 bankruptcy, the debtor remains in possession of its assets and continues normal business operations while reorganizing debt obligations and repayment plans. This is in contrast to a Chapter 7 liquidation, in which the debtor’s assets are sold to pay off debts and the bankrupt company ceases operations. In some cases, debtor-in-possession may refer to a legally appointed trustee, someone other than the actual company that is in bankruptcy, who oversees the assets during the reorganization.

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debtor in possession

See Also:
Chapter 11 Bankruptcy
Chapter 12 Bankruptcy
Bankruptcy Costs
Bankruptcy Courts
Chapter 13 Bankruptcy
Bankruptcy Code
Bankruptcy Information
Secrets of Successful Out of Court Debt Restructures
Tips on How to Manage your Lawyer
Relationship With Your Lender

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